From Passive to Active Investors: Why Institutional Investors are Taking on an Active Role to Promote Corporate Governance Best Practices

Kern McPherson joined Glass Lewis in 2009 and currently leads the North American research teams covering corporate governance, executive compensation and environmental & social topics at over 6,500 companies traded in the U.S. and Canada. Kern specializes in issuer engagement and corporate governance analysis, and is an active participant in Glass Lewis’ policy and product development. Kern is also a frequent speaker on corporate governance topics, including panels hosted by the ICGN, the Society for Corporate Governance, NACD, the Toronto Stock Exchange, and others. Prior to joining Glass Lewis, Kern served as a senior account manager and business analyst for large corporate retailers. He holds a bachelor’s degree in English and History of Art & Architecture from the University of California, Santa Barbara.

Christopher P. Skroupa: How do you define the difference between a passive and active investor?

Kern McPherson: Over the past decade, billions of dollars in assets have flowed from actively managed funds, which frequently buy and sell stocks, into passive investments such as index funds, ETFs and many public pensions. While passive in name, these institutional investors are becoming more active than ever in pushing companies to adopt corporate governance best practices and a focus on long-term shareholder value. These investors may more aptly be called “permanent capital.”

The shift toward passive investing coincides with a rising emphasis on investor stewardship, globally. By demonstrating responsible stewardship of assets, institutional investors encourage the long-term sustainability of the companies in which they invest, while making their portfolios more attractive to a new generation of investors who want their retirement savings invested in an environmentally and socially responsible manner.

Skroupa: How is the role of the passive investor changing the engagement landscape and why?

McPherson: Engagement has become an essential component of investor stewardship. For example, the Investor Stewardship Group (“ISG”), a collaboration of 50 U.S. and international institutional investors with an aggregate $22 trillion in U.S. investments, underscores the necessity of proactive engagement in their principles for stewardship and corporate governance. They state that institutional investors should “resolve differences with companies in a constructive and pragmatic manner” and that public companies should “be proactive in order to understand [investor] perspectives.” For both investors and the companies whose stock they own, there is now an expectation for direct and ongoing dialogue around issues that are material to the company’s long-term performance.

Proxy voting at shareholder meetings, historically treated as a matter of compliance, has become a powerful lever of change. The advent of mandatory say-on-pay votes in the U.S. in 2011 hastened this change by casting a public spotlight on executive pay. In turn, the traditional mode of corporate outreach evolved to include direct dialogue between companies’ compensation plan designers and proxy voting teams. In recent years, that dialogue has evolved beyond pay, into topics such as board diversity and environmental and social sustainability. The breadth and depth of the engagement discussion has grown significantly and continues to expand.

Skroupa: How do you see these changes affecting the shareholder engagement process?

McPherson: As engagement becomes more frequent and covers a broadening range of subject matter, both investors and companies are realizing that engagement isn’t easy. The logistical challenges alone are significant, especially for large institutions with thousands of holdings. To meet this challenge, institutional investors are expanding their proxy voting teams to include a diversity of topical expertise and incorporating new technologies to assist in scheduling meetings, recording notes, and sharing insights across their organization. Whereas proxy teams historically enjoyed downtime following the busy annual meeting season, these months have now become a busy “engagement season” of their own.

Public companies have rose to the challenge by re-thinking their shareholder outreach process. Boards of directors are increasingly prepared to engage directly with their large investors, and the nature of a two-way dialogue means they must be prepared to respond to difficult questions on topics outside the purview of required SEC disclosure. The conversation has become more candid and meaningful.

Skroupa: What effects do you see these changes having on how companies behave, more specifically regarding how they align with investment priorities?

McPherson: Companies have enhanced their proxy disclosures to better align with the needs of institutional investors, and this enables investors to make more contextual voting decisions. For example, disclosure is increasingly presented in an efficient tabular format, with more emphasis on meaningful context, and less use of boilerplate language. Disclosure above and beyond the minimum SEC requirements (e.g., the inclusion of a board skills matrix) suggests a better understanding of the factors that institutional investors consider when casting votes. Companies have also heard the demand for more detailed disclosure around ESG factors, and many are now producing corporate social responsibility reports.

Companies are demonstrating a better understanding of how corporate governance and sustainability can have a material impact on long-term corporate performance. Criteria such as environmental impact or reputational risk, once viewed as secondary concerns for a subset of investors, are now front and center in public company outreach and disclosure.

Engagement has also been key in the push for board diversity by passive and active investors alike, and companies are increasingly aware of institutional investor policies on the topic. In 2018, nearly one-third of new director nominees were women, the highest percentage in a decade. While there is still a long way to go to reach gender parity on public company boards, engagement between companies and institutional investors, particularly by “permanent capital” investors with an eye on long-term shareholder returns, is spurring positive change.

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